By Zachary Atkins and Andrew Appleby

The Indiana Department of State Revenue upheld an audit determination that an intellectual property arrangement between a parent company and its wholly owned subsidiary distorted the parent company’s income. The parent company, a separate-return filer for Indiana, adjusted gross income for tax purposes, and transferred to the subsidiary, in an I.R.C. § 351 transaction, the right to sublicense the parent company’s intellectual property. The subsidiary was not required to pay royalties to the parent company for the use of the intellectual property. The subsidiary sublicensed the intellectual property to foreign affiliates in exchange for royalties, which the subsidiary paid as non-taxable dividends to the parent company. The parent company reported considerable expenses, including expenses related to the maintenance, development, and enhancement of the intellectual property, and large net operating losses on its Indiana returns for the years in question. The subsidiary, in contrast, reported nominal expenses while collecting more than $200 million in royalty income. The Department concluded that the arrangement, which it characterized as non-arm’s-length, was distortive because it allowed the parent company to claim significant expenses while earning substantial income in the form of non-taxable dividends. Exercising its discretionary authority to allocate the Indiana income of related entities to fairly reflect a taxpayer’s Indiana income, the Department allocated the subsidiary’s royalty income to the parent company to correct the perceived distortion. Ind. Dep’t of State Revenue, Letter of Findings No. 02-20140358 (posted Jan. 28, 2015)